I read an article recently on Bigger Pockets about High Interest Rate Private Financing that I want to discuss. We offer private financing options to our clients seeking a way to buy investment property with leverage, but a lot of people balk at the interest rate. Borrowing money for buying investment property is becoming more difficult today because of the credit crisis, which is why private lending is an attractive alternative. But the high interest rate can result in a monthly P.I.T.I. payment that takes a serious “chunk” out of your monthly cash flows, and may result in no positive cash flow at all! Is this really a good deal?
I’m often asked by new investors exploring options for buying investment property about how to properly evaluate deals. The answer is… “IT DEPENDS!” It depends on YOUR PORTFOLIO OBJECTIVE- what are you looking to accomplish? Are you seeking positive cash flow now, or equity build up for the future? Ideally, you’d like to have both, but most of the time you have to compromise one for the other. And depending on your short-term and long-term goals, what may be perceived NOT to be a deal with one strategy (i.e. short-term positive cash flow) is actually a great deal with another strategy (i.e. long-term equity build up).
Getting back to our discussion of buying investment property with high interest rate private financing, let’s assume that you can get a private loan for 50% down and 12% interest amortized for 100 months (8.3 years). Because the interest rate is so high and the amortization period so short (compared to 15 – 30 year am’s at traditional financing institutions) your monthly P.I.T.I. payment will “suck up” the majority of your gross monthly rents collected. Assuming you conservatively budget 4 months of gross rents per year to cover admin expenses on the property- property management, taxes, insurance, maintenance, and vacancy, your NET income will be 8 month’s of collected rent. Subtracting your mortgage payment from this will yield an effective Return-on-Investment of ~0.50% on your 50% cash down payment in the first year for this property.
Just looking at ROI = 0.50% for Positive Cash Flow would lead you to believe that this is NOT a good deal! Certainly this is not a good deal compared to the 9-11% ROI you would get on the positive cash flow from an all-cash purchase of this same property. However, if you analyze this deal more closely and factor in the RAPID EQUITY BUILD-UP from paying down the loan over time, you’ll actually see that your first year ROI would be just shy of 8%, second year around 9%, and in the third year you’re actually ahead of where your ROI would be from an all-cash purchase! This is because you’re RAPIDLY BUILDING EQUITY in the property by paying back the private loan in a short amount of time. Further, the real benefit comes at the end of the loan when the property is paid for and debt-free… plus, assuming you used leverage and ACQUIRED 2 INVESTMENT PROPERTIES instead of just the 1 you would’ve had you paid all cash, now you have 2 FREE AND CLEAR rentals in less than 10 years using private financing! And, your tenant is paying down the loans… not you!
So, when considering options for buying investment property, if you’re willing to trade off positive cash flow in the short term (1-3 years) for rapid equity build up, you can actually acquire properties with leverage and build long-term wealth quickly. Again, it all depends on your individual portfolio objective and your investing goals. Cash Flow or Equity Build Up? Which is more important?
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